Credit Spreads Explained with Netflix

Playing the Expiry: October 26, 2012

Technology companies are getting no love from traders so far this earnings season. Google (GOOG), Microsoft (MSFT), and Intel (INTC) finished the week on sour notes with gloomy reports and that hurt the NASDAQ substantially. And it might be another week of pain for investors as more tech stocks are starting to report.

Household names will be reporting this week, including Facebook (FB) and Netflix (NFLX) on Tuesday, and Apple (AAPL) and Amazon (AMZN) on Thursday. This week will definitely prove to be a turning point for the American markets.

Reporting earnings after hours on Tuesday, expect Netflix (NFLX) shares to make a big move. This stock has a very high beta and a 5 per cent move in an hour is not unheard of. That's why option premiums are so delicious for sellers. The last four earnings reports have moved shares at least 17 per cent, with the biggest move occurring last year on this date, falling about 35 per cent.

Trading Netflix is not for the faint of heart, and for those looking to get into options trading, I highly recommend due diligence. Credit spreads to maximize losses might be a wiser approach than simply writing a strangle, but of course this eats away at potential profits.

Before we begin to write the credit spread, we must examine the risks and rewards. Netflix at-the-money options are pricing in a 16 per cent move, but I would suggest protecting yourself from a 20 per cent move. With shares currently at $68.25, that gives us a range between $81.90 and $54.60. The nearest strike prices would be the 80 call and the 55 put. The premiums on the call and put are $0.99 and $0.70 respectively, yielding against the stock price, a return of 2.48 per cent, but more accurately, yielding a return of 6.21 per cent against margin. Because the options are so out of the money, the net margin required would be about $2,600 per pair of legs. But just remember that Netflix is a 50 per cent marginable stock.

The second step in a credit spread is buying further out-of-the-money options to maximize your loss. In this scenario, the exchange has only provided one choice. A trader would buy the 85 call for $0.44 and 50 put for $0.26 to provide a net credit to the account for $0.61 and $0.44. This limits the yield to 1.54 per cent against the stock price, but yield on margin rises to 26.7 per cent (margin required is the maximum loss [$500] minus premiums [$105] or $395). Yield on margin is a more accurate measure of returns, since that is the actual cash required to implement the trade.

Similar to the naked strangle (that is, the trader does not implement the buying of options), the profit range is still the same. If Netflix remains between $55 and $80 by Friday, full premiums are collected. The main difference is that the margin on the credit spread is reduced substantially, but has a tighter break-even range.